New dimension to revenue expenses - Extension of trading (or other) business for manufacture of traded products- a possible way to save tax because many expenses yielding enduring benefit can be allowed.

[Uma Kothari]

Brief note:

Delhi High Court in case of a dealer / trader held that preliminary expenses and expenses for setting up manufacturing facility for manufacture of same or similar products which are traded, as one and same business or  as an extension of  existing business (trading activity in this case), may be allowed as revenue expenditure. This is very remarkable judgment, however, it is likely that the revenue will challenge it before the Supreme Court.

The judgment is reported as CIT v. Relaxo Footwears Ltd., [2007] TMI 1962 (Delhi) and it lays down new dimensions on the concept of 'revenue expenditure'.

Trading business:

The assessee may be engaged in business of trading in certain items and for that the assessee is required to have business spaces in nature of office / sales office, showrooms, shops and godowns etc.  Now-a-days in due to communication, fast delivery of goods and advanced manner of trading activities including web based e-commerce, the requirement of offices and warehouse have also reduced.  In practical life, we find that in a trading concern requirement of fixed assets is very low and major part of the capital is required for working capital mainly for stock-holding, sundry debtors, advances to suppliers and organizational expenses etc.

Manufacturing business

In case of manufacturing business, we find that in case of manufacturing undertaking, the requirement of fixed assets as well as working capital is more in comparison to trading activity because manufacturing activity involves holding of manufacturing facilities, raw material and process material, stores for such material. There is more lead-time for the process of purchasing of raw material to the sale of goods.

Therefore, we find that there are substantial natural differences in two activities. 

Manufacturing of traded item- an extension of trade:

When a trader starts to manufacture various items, which he used to trade in earlier, there is expansion of business in the same line of various products.  By establishing a manufacturing facility, the trader reduces his dependence on other manufacturers of the traded product and he can assure the regular supply and better quality control on the products to be manufactured and sold to the customers.  In such a case, the customer base of the trading concern will be immediately available to the trader turned manufacturer.  Therefore, there is ready available market for the product to be manufactured. 

Manufacturing under job work:

Large trading houses / well known brand ownere get various products manufactured from others as per own specification and stamp with brand owned by the trading houses.  This is called an activity of trading of outsourced product under own brand.  If that were the case, then the extension of business from trading to the manufacturing with own specifications and brands becomes a clear case of expansion of the business.

The same organization / company

To take the benefit of goodwill, reputation, and customers base it is desirable that the manufacturing activity be carried in the same company or organization in which the trading activities are carried.  Furthermore, having business in the same unit also gives advantage of saving on account of taxes due to in housing services of manufacturing and marketing. Therefore, unless there are other compelling reasons like requirement of financiers or technical collaborators, the businessman would prefer to carry the business in the same company or the same organization in which the trading activity was carried on.

One and same business:

The concept of 'one and the same business' has been examined by courts in context of different provisions like set off of current losses and brought forwarded losses. The broad principal is that if two business are owned by the same person then it can be one and same business of the person if there is unity of control, interlacing of activities, interlacing of financing, common organization and other facilities, and one integrated balance sheet and profit and loss account for the owner of all such businesses. More transactions between different units as unit owned by same person and more dependence and interlacing between units will make the case strong to establish that all such units constitutes one and the same business. This concept has been extended to allow certain expenses, which are of capital nature in case of a stand-alone unit, as revenue expenses because setting up of the new unit is considered as extension of the same business.

Expenses for setting up of manufacturing facility allowed as revenue expenses

In the accounting treatment, the expenses incurred for preliminary reports and pre-manufacturing expenses as well as the expenses for setting up of manufacturing facility are considered as capital expenses and amortised according to the method of accounting followed by the assessee / company.  This is also required to comply with the accounting standards and the requirement of the Companies Act or other application of law.  However, it is well known that under the provisions of Income-tax Act, the accounting treatment is not conclusive and the provisions of the Income-tax Act would prevail over the accounting treatment while computing the taxable income.  According to the provisions of the Income-tax Act, some expenses debited in the profit and loss account may be disallowable or some expenses capitalized in the account may be allowed.  Similarly, the treatment of income under the accounting method and the Income-tax Act may be different.  The item not shown as income in profit and loss account may still be taxable or an item shown as income in the profit and loss account may not be taxable being exempt from tax or being a capital receipt or for some other reason like being contingent income not yet accrued with certainty etc.

CIT v. Relaxo Footwears Ltd [2007] TMI 1962 (Delhi)

The assessee was engaged in trading in all kinds of rubber footwear, to take advantage of its trading base it setup a new unit and commenced the business of manufacture and sale of hawai chappals- a product which was traded by the assessee earlier.

 The assessee claimed deduction of pre-operative expenses, expenses incurred on the new factory and capital issue expenses. The Assessing Officer disallowed these claims treating such expenses as capital expenses. On appeal the Commissioner of Income-tax (Appeals) allowed some of expenses.  On cross appeals the Tribunal allowed the appeal filed by the assessee and dismissed the appeal of the Revenue.

The Tribunal concluded as follows: -

" the expenses incurred by the assessee for the setting up of a new unit which was a part of the existing business are therefore to be allowed as a revenue expenditure."

 On further appeal the Revenue contended that

(i)   the expenses incurred in a new unit earlier to the commencement of the manufacturing process had to be capitalized and the new business of the assessee could hot be said to be an extension of the existing business,

(ii)  the expenditure incurred in connection with the purchase and installation of plant and machinery was capital in nature and thus disallowable, and

(iii)  the pre-operative expenses could not be written off at one go but had to be capitalized and admissible depreciation/ amortization allowed thereon:

And the High Court held as follows: -

Held, dismissing the appeal, that the new unit was a part of the existing business and there was no dispute that there was unity of control and interlacing of the units.  Thus the expenses incurred by the assessee for the setting up of the new unit, which was a part of the existing business, were therefore to be allowed as revenue expenditure.

No fault can be found with the view taken by the Tribunal.  Thus, the order of the Tribunal does not give rise to a question of law, much less a substantial question of law, to fall within the limited purview of section 260A of the I.T. Act, which is confined to entertaining only such appeal against the order which involves a substantial question of law.

Accordingly, the present appeal filed by the Revenue, is hereby, dismissed.

The crux of the matter:

While arriving at the above decision to allow such expenses, the main consideration by the tribunal and the court was that the expenses were incurred in the existing and same business.

A Very beneficial judgment however, a situation of doubt

The above judgment of the Delhi High Court approving the order of the Tribunal which was based on the judgment of Supreme Court in case of Standard Refinary & Distillery Ltd. (1771) 79 ITR 589 and the other cases referred therein and also judgment of Delhi High Court in CIT v. Modi Industries Ltd. (1993) 200 ITR 341. 

The decision in the case of Standard Refinary was related with setting off of losses suffered in different departments or divisions carrying different types of business of manufacture of sugar, distillery and dealing in shares. As these businesses formed part of one and the same business due to interlacing of activities, common management, common control common balance sheet etc. therefore, the losses were allowed to be set off.

The case of Modi Industries related to allowability of debenture issue expenses for capital raised for a new steel unit, which was an extension of the existing business as there was unity of control, common fund, and interlacing of activities etc. Therefore, the expenses were allowed as revenue expenses. In this regard it can be said that raising of debt and raising of capital are considered different. In case of raising of borrowed capital there is no acquisition of any capital asset, whereas in case of raising of share capital it is considered as expenses of acquiring a capital base.

A manufacturer can claim expenses of setting up second unit or expansion of same unit:

Applying the principle a manufacturer can also claim expenses for expansion of same existing unit or in setting up of a new unit if the new unit also constitute one and the same business on application of various tests.

A professional firm can claim expenses for setting up branch office:

Applying the same test any professional person like CA/ CWA/CS/ Doctor/ Advocate etc. can also claim expenses for setting up a branch office as revenue expenses because the activities carried at branch will also be interlaced with HO and it will be part of the same business.

Very beneficial orders:

Though the order of the Tribunal and the High Court are based on ruling of Supreme Court applied on major principle to examine whether the new business is part and parcel of existing business.  However, the doubt which remains, is that whether a capital expenditure can be allowed while computing income otherwise than by way of permitted amortization.  This is because we find that any cost of new plant or machinery even in an existing unit is treated as capital expenditure.  Even a replacement of machine in existing unit is considered as capital expenditure and the cost of new asset is added to the cost of relevant block of assets and then depreciation is provided in the accounts and is claimed in the computation of income.  Therefore, allowing all expenses including expenses on plant and machinery of a new unit as revenue expenditure merely on the ground that the new unit and the existing business constitute one and same business is extremely doubtful.

Start trading and then setup manufacturing facility:

If the above view is applied then any person who wants to start an industrial unit can be advised to first start a trading activity of similar item and then set up a manufacturing unit and claim entire costs of setting up of the new project as revenue expenditure.  In this regard, one more aspect to be considered is that as per section 145(1), income chargeable under the head "profits and gains of business or profession" or "income from other sources" shall subject to the provisions of sub-section (2) be computed in accordance with either cash or mercantile system of accounting regularly followed by the assessee. 

As per section 44AA, the assessee maintains books of account from which the profit and loss account is drawn up and as per section 44AB, audit of accounts, popularly known as tax audit report has to be obtained and in the tax audit report there is a provision to report if any capital expenditure has been debited in the profit and loss account or not.  While reporting under this head, expenses of setting up of a new unit or setting up of a new department or a new process house or even installing a new machine after or before discarding old one is considered as capital expenditure.  If such sums are debited to the profit and loss account then the tax auditor is required to report that such capital expenses have been debited in the profit and loss account.  While reviewing returns of income or while preparing appeals etc. the author has come across reporting of capital expenditure even for petty items like calculator or telephone hand set purchased to replace old one and even when the new purchase is in exchange of old calculator or the telephone hand set or similar item, therefore, the questions are whether the assessee can prepare separate profit and loss account for the purpose of computation of income as well as book profit and debit all such capital expenses which are incurred for the existing business as revenue expenditure and whether the tax auditor can enclose such account to his tax audit report and say that any capital expenditure is not debited in the profit and loss account.

Based on the ruling of Delhi High Court it appears that the assessee and the tax auditor can adopt such a practice.  However, it would be advisable to specifically mention the facts and circumstances and judgments which are directly applicable and which are relied on to treat any such expenses as revenue expenses.